Monday, October 31, 2011

Federal Reserve Not Immune From Law of Unintended Consequences

Twist Puts Looney Tune Squeeze on Citizens

Federal Reserve Chairman Ben Bernanke recently announced that the Federal Open Market Committee (FOMC) would begin a process informally known as “Operation Twist,” in which the Federal Reserve will attempt to force long term rates downward while letting short term rates rise.

This will be accomplished by selling short term treasuries and purchasing longer term ones with those same funds. Bernanke believes that this will aid the economy by allowing individuals to refinance at lower rates, thereby providing support for real estate markets and yielding an increase in consumer spending money.

With this announcement, Mr. Bernanke has proven once more that elaborate theories crafted by geniuses always yield results even Wile E. Coyote himself could not devise a more promising scheme if left alone in the desert with stacks of economic data.

If by now you’re wincing just a bit, it could be because you know that reality comes with its own set of rules. Attempting to manipulate markets to achieve a desired outcome may appear logical…. it might even seem like the right thing to do on many occasions, but the law of unintended consequences always does exactly what you don’t expect, as its name implies.

Economic recovery in this environment is not unlike the Road Runner. Each time you think it can be had, it leaves you looking silly. What we need is an elaborate plan—or two…or even three.

The problem is that we have already made these attempts. First, there was QE1, then there was QE2. Both were extravagant and expensive ways to attempt economic stimulus. And now, because the first two were so successful, this third round of tinkering is being forced upon the public by a Fed Chairman concerned with his own job security.

First of all, we must consider those who depend the most upon a healthy and normal yield curve. Retirees, pensions, and small to regional banks depend more on long term rates to yield an acceptable rate of return than most other segments of society. Yet, Operation Twist is taking from those who have worked and saved, pressuring pension funds which are already stretched thin, and tilting the board to favor the megabanks which have far more diverse revenue streams – banks that have already been bailed out once.

In addition, only those people who qualify for refinancing will be able to benefit from these lower rates—if the bank is willing to lend at all—but those on the edge of walking away from their mortgages will see no reason to change their minds. As a result, real estate values will remain soft from the glut of homes on the market.

Perhaps some young couples starting out could benefit from a real break. If left alone, they will soon have saved enough money to do the things that move economies.

They could start a business and hire people. Perhaps their local bank would lend them money for commercial property if rates were attractive. Maybe Grandpa could have helped them out in a tight spot if his cash flow wasn’t restricted by a meddling little man in a far away place with a fancy title and wild ideas.

Henry Dillon is the Principal/Adviser with Founders Finance, LLC located in Huntington, WV. For further information, please visit their website at www.foundersfinance.com